In the Catbird Seat

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Between the weak economy, the financial-reporting crisis, and a terrorist threat of uncertain dimensions, public investors are holding on to their purse strings with both hands these days. With good reason. In the first quarter, 94 companies defaulted on their bond payments, an all-time high and 60 percent more than the previous record of 59 in the fourth quarter of 2001, according to Standard & Poor’s. Moribund stock prices have killed the initial public offering market and made secondary offerings prohibitively expensive for most public companies.

Banks aren’t picking up the slack either. With scores of problem loans to manage, they are focused more on watching their balance sheets than on lining up new business. As a result, capital is hard to come by for public and private companies alike.

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In theory, it is in times like these that private investors step up to the plate. Institutional investors have lots of experience. Since public market values have fallen so far, they also have more opportunities than they have had in years.

In reality, however, they are only beginning to go bargain hunting. For the past 18 months, private equity and debt investors largely sat on the sidelines along with public investors. With no exit strategy through the still-disabled IPO market, most equity groups are holding devalued investments and are wary of making new commitments. “At best, they’re proceeding cautiously,” says Moody’s Investors Service economist John Lonski. “And they’ll probably continue to do so until they see their future returns more clearly.”

There are some encouraging signs, however. The private placement market for corporate debt remained firm last year, with commitments of $23.6 billion in 2001 versus $20.8 billion the previous year. And at this point, private equity groups are sitting on an estimated $150 billion in funds raised during the past few years–enough to burn a hole in the most cautious pocket.

“There’s a lot of pent-up demand out there,” says Anthony DeLuise, head of private placements at Credit Suisse First Boston in New York. “Since September 11, institutional investors have been waiting to come back into the market, and they have to put their money to work.” When they do, it’s increasingly likely to go into the private placement market before publicly traded securities.

Attention Deficit

For the most part, private placements are made by companies that are unable to access cheaper public debt. “If you can’t issue more than $200 million, it’s tough to get attention in the public markets,” says Allen Weaver, Chicago-based senior managing director at Prudential Capital Group, which invests in investment-grade as well as mezzanine debt. “We have plenty of money to invest.” One of the largest players in the private placement market, Prudential Capital had originations of $3.6 billion in 2001 and managed a portfolio of $31 billion at the end of last year.

What private placements give up on price to public offerings, they make up in other ways. The first is speed. A private placement doesn’t require registration with the Securities and Exchange Commission, and can usually be arranged in a fraction of the time needed for a public offering.

What’s more, private companies don’t have to make financial disclosures to the market, and can usually tailor the securities to their specific needs in terms of maturities and principal payment schedules. Private placements also provide a much-needed alternative to short-term bank debt, says Weaver. “In the 1990s, bank financing was cheap,” he says. “Now the banks are raising their prices and cutting their exposures.”

And the private placement market has become all the more important for midmarket companies. Jerry Whiteford, CFO of Elkhart, Indiana-based Nibco Inc., a privately held company in the flow-control industry, says that privately placed debt is a vital source of financing diversification for his company. “With all the bank consolidation, our syndicate financing options are fewer,” he says. Despite the fact that cheaper short-term bank credit is readily available, Whiteford has historically arranged 40 percent to 60 percent of his debt financing through private placements. “I look at private placements as a piece of our long-term capital,” he says.

The biggest investors in private placements — insurance companies and pension funds — typically hold the securities until maturity. But that isn’t always the case.

Choosing the right investors is key, says Hal Logan, CFO of TransMontaigne Inc., a refined-products distribution company based in Denver. “You want a long-term partner that will hold the securities for at least three to five years,” he says. Patient, long-term investors are also apt to commit to more funding if the company requires it down the road.

When it comes to private equity financing, finding good investors is all the more important. As Seth Lemler, managing director with Morgan Lewins & Co., a New York-based investment bank serving midmarket companies, puts it, “You’re going to be living with these people for a long time.”

For private companies, vetting potential investors amounts to determining what the company needs and whether or not the investor is a suitable fit. For public companies, the decision can be of much greater consequence.

Cleaning the Pipes

Mention the word PIPE (private investment in public equity) to a public company CFO, and he’s apt to recoil in horror. He’s sure to have had the idea pitched to him, and he’s also sure to have heard of companies that have spiraled into bankruptcy soon after arranging one. Dozens of floundering companies, including eToys, AtHome, and Winstar Communications, have slid into financial ruin in part because of PIPEs gone awry.

The favorite form of PIPE is the convertible preferred share, which gives holders the right to convert their shares into common stock, typically at a premium to the company’s share price at the time. As valuable as a long-term private investor can be for public companies, the private market also has predatory investors that, when they smell blood in the water, will move in for the kill.

Certain hedge funds and private equity groups have pushed more than a few companies into a “death spiral” with so-called toxic convertibles that have exercise prices that reset if the public stock price falls. However supportive a private investor might seem, a floating conversion rate provides incentive for an investor to work against a company–shorting the public stock to lower the conversion price of the preferred shares.

The result can be a snowballing dilution that swamps public shareholders. “You dance with the devil when you have to,” says Lemler.

Companies can and do set conditions that the investor cannot work against them. But that doesn’t stop other investors from selling stock short. The negative publicity surrounding toxic convertibles, however, has helped clean up the PIPE market. And with so much private capital looking for a home, growing numbers of public companies are tapping the market.

“Not all PIPEs are bad,” says Lemler, who helps public and private companies find suitable private investors. “People have wised up, and there are a lot fewer abuses in the market.”

When structured correctly, a PIPE can provide essential capital and a potentially valuable business partner for a public company. TransMontaigne’s Logan says several large private investors have remained shareholders since the company went public in 1997. “We look for investors who’ve been in hot kitchens and don’t get uncomfortable,” he says.

Very often, private investors can provide valuable management help and strategic support for a public company as well. Consider Salton Inc., headquartered in Lake Forest, Illinois, a maker of home and kitchenware products such as the George Foreman Grill. Three years ago, CEO and founder Leon Dreimann needed $80 million to buy back 6.5 million shares from another company, Windermere. Through boutique investment firm Barrington Research, Dreimann hooked up with New York-based private equity group Centre Partners. Centre came up with half the equity in the form of preferred shares, and the banks provided the rest.

Today, two Centre partners still serve on Salton’s board. “They’ve made a major contribution to our business,” says Dreimann.

With public stock prices the way they are, a lot of capital-strapped companies could use that kind of help.